BRUSSELS Dec 20 (Reuters) - Europe must complete its plan to create a banking union, improve stress testing of banks and separate bank and sovereign risk to overcome the sovereign debt and bank crisis, the IMF said on Thursday.
In an assessment of the European Union's financial sector, the International Monetary Fund said the 27-nation bloc has made significant progress in recent months to strengthen the sector, but needed to complete the process without delay.
"The crisis reveals that handling financial system problems at the national level has been costly, calling for a Europe-wide approach," preliminary conclusions of the IMF report said.
The IMF praised Europe's decision to set up a single bank supervisor (SSM) in the EU based on the European Central Bank, but noted more was needed.
"The SSM is only an initial step toward an effective banking union - actions toward a single resolution authority with common backstops, a deposit guarantee scheme, and a single rule book, will also be essential," the IMF said.
EU leaders have agreed to try to harmonise national resolution procedures for dealing with banks in financial trouble and also deposit guarantee schemes in the first half of 2013. During that year the European Commission is also due to propose how to set up a single bank resolution fund for all countries that take part in the SSM.
The IMF said European authorities should better test their banks for scenarios of financial crisis or economic downturns.
"European stress-testing needs to go beyond micro-prudential solvency, and increasingly serve to identify other vulnerabilities, such as liquidity risks and structural weaknesses," the IMF said.
"Confidence in the results of stress tests can be enhanced by an asset quality review, harmonised definitions of non-performing loans, and standardised loan classification, while maintaining a high level of disclosure. Experience suggests that the benefits of a bold approach outweigh the risks," it said.
To stop the negative feedback loop between highly indebted sovereigns bailing out their banks, which, in turn, buy the sovereign's bonds, the IMF said the euro zone's bail-out fund, the European Stability Mechanism, should quickly be able to recapitalise banks directly, not through lending to sovereigns.
"Measures must be pursued to separate bank and sovereign risk, including by making the ESM operational expeditiously for bank recapitalisations," it said, reiterating its longstanding position.
EU leaders have agreed that the ESM would be able to directly recapitalise banks as soon as the ECB effectively takes over its supervisory duties, which is set for March 1, 2014.